Why we believe the financial industry needs its own transition as it seeks to help companies become sustainable.
Key Points
- The earliest definitions of responsible investment centered on the avoidance of certain business activities for moral or value-driven reasons. Following the global financial crisis, some regions elevated the importance of stewardship and long-term value creation, and the traditional shareholder model was challenged by the stakeholder model.
- Moving on to the last five years, the responsible investment industry has entered a rapid expansion, turned its focus to ‘sustainability’, and collectively mobilized around the commitment to work with companies in their transition to becoming sustainable.
- For the investment industry, a key part of the transition is integrating the way that we think about material ESG issues into our investment processes. While this trend has accelerated, we believe significantly more needs to be done to rethink the way in which we allocate capital, so that we can create a truly integrated investment model that is transformational to the global economic system.
The traditional approach to investment was not designed to tackle the planetary boundaries that are all too apparent in today’s world. Neither was the original form of socially responsible investing (SRI). But while the industry has belatedly woken up to its central role in creating a truly sustainable future, we believe a more fundamental overhaul is needed if we are to collectively succeed in tackling the biggest external threats facing society.
A Big World on a Small Planet
Traditionally, asset management has followed the neoclassical model – the assumption that the exchange of goods and income takes place inside a closed loop, without energy and material inputs. This approach faced little disruption when we were part of a ‘small world on a big planet’, but it is clear to us that we are now part of a ‘big world on a small planet’, and the planetary invoices are starting to pile up.
In response to this, we believe that investors need to embrace an alternative way of thinking about an economy that is based in a physical world which is defined by planetary boundaries. Only then can we truly start solving the vast array of 21st century challenges and begin internalizing the negative external consequences that have been building up around us for decades.
Evolution: From Screening to Stewardship and Integration
Responsible investment was not originally built around this philosophy or the approach of looking at the harmful impacts that companies may have on the environment and society. The earliest definitions were instead rooted in (and centered on) the avoidance of certain business activities for moral or value-driven reasons. I think of this ethical screening as ‘phase one’ in the development of the responsible investment industry. In my view, much of the recent politicization of the industry and its commitment to environmental, social and governance (ESG) analysis stems from a misplaced understanding of this early approach.
The financial services industry continued to evolve in the early 2000s when the term ‘ESG’ was coined, with the emphasis placed on the importance of ‘integrating’ ESG issues as part of fundamental analysis. Following the global financial crisis, some regions, particularly the UK and Europe, elevated the importance of stewardship and long-term value creation. The traditional shareholder model was challenged by the stakeholder model. This could be considered as a new phase for responsible investment, which would come to dominate for well into the next decade, at least in Europe.
During this period, ESG and responsible investment teams were formed, and asset managers started to consider sell-side (firms issuing, selling, or trading securities) analysis – albeit not integrated into company recommendations – on sustainability themes and ESG topics. Advocacy groups such as the United Nations’ Principles for Responsible Investment (PRI) were attracting more and more members, and the acid test used by asset owners such as pension schemes started to be whether investment managers had made a commitment to those frameworks.
We were asked to send lists of groups and initiatives we were signed up to and, for a while, there was an almost silly competition to make the list as long as possible. Substance came second to the race to boost engagement numbers and ESG team members. At the same time, a new commercial angle to the market was dawning: the rise of the ESG service providers.
One of my first jobs was as an analyst with one of these firms – CoreRatings, which, many acquisitions later, ended up as part of MSCI. While we may have wished that the reports would have been used more widely, they were mainly purchased to support various shades of sustainability funds.
Under Growing Scrutiny
Compared with today, the industry was pretty slow-moving until relatively recently. Attention to ESG credentials tended to tail off when markets were challenging, and those credentials were regarded almost as a ‘nice to have’ when times were less turbulent. The data was still young, and didn’t allow for the type of statistical analysis that was required to draw any correlation conclusions. The discussion around ESG alpha and whether ‘ESG integrated funds’ or ‘sustainability funds’ would outperform became a huge debate, and, to an extent, blinded the discussion around what was a fairly simple economic argument: that future returns could be estimated, for example, without any consideration of the biophysical boundaries or the potential negative consequences of social impacts related to labor or a social license to operate. In fact, even though investors have allocated capital for decades around risk and uncertainty, few approaches have been scrutinized and challenged for undisputed evidence as much as the concept around considerations of ESG aspects.
As the asset-owner community evolved, alongside asset management, clients started probing the integration processes in more detail but, for too long, the dialogue was with ESG/responsible investment teams and remained largely a separate conversation from mainstream investment due diligence. Only the leading asset owners would directly challenge portfolio managers or chief investment officers about how ESG considerations played a part in investment decisions.
Company executives would repeatedly tell us that they either didn’t receive questions on ESG issues at all or, if they did, they came via an ESG analyst who, in many instances, did not have business-relevant insights. While the financial skillset has evolved within the ESG community, we believe it still suffers from being dominated by people who bring only one skillset to the table. In fact, another discussion has been around whether ESG analysts should evolve into financial analysts, or whether financial analysts should become ESG analysts, and I would advocate that ESG analysts can certainly be transformational by enabling colleagues to think about ESG risks, issues and opportunities as part of the investment process.
At a Crossroads
Moving on to the last five years (and to an extent accelerated by the Covid pandemic), the responsible investment industry has entered what I think of as ‘phase three’ – a rapid and unprecedented expansion and a new focus on ‘sustainability’. I have probably experienced more change and developments in the last five years than in my first 15 years working in financial services. I believe we are now at a critical crossroads where we should be better placed than before to appreciate and understand the transformation needed in our industry, so we can invest in the changes we believe are required across mainstream investment capabilities. We are now living in times when the consequences of ignoring sustainability are creating genuine costs and disruptions to us: these are no longer considerations that will affect us at some indeterminate point in the future.
Against this backdrop, the asset-management industry is now busier than ever when it comes to talking about and working with companies to help them become sustainable businesses. Nowhere is this trend more evident than where it involves engagement with energy companies and other businesses that are central to one of the biggest existential risks created by our society: climate change.
As an industry, we have collectively mobilized around the strong message and commitment to work with such companies in their transition to becoming sustainable. While ‘transition’ may have many definitions in the market, we view it as meaning the evolution of a business model by reducing and mitigating its most material negative ESG consequences. This concept is not unique to the energy system. For the investment industry it means, among other things, integrating the way that we think about material ESG issues into our investment processes. This trend, which has been in motion for over a decade, has accelerated in recent years. While we view this is a positive development, our observation is that significantly more needs to be done to rethink the way in which we allocate capital, so that we can create a truly integrated investment model that is transformational to the global economic system.
In Europe, following the implementation of the Sustainable Financial Disclosure Regulation (SFDR),[1] and other regulatory changes that accompanied SFDR, there is growing demand for funds that can demonstrate sustainable outcomes through promoting environmental and social (E and S) characteristics, or through having a dedicated E and/or S objective alongside their financial objective. This implies that the funds have an incentive to consider E/S factors above and beyond managing their risk-reward profile.
Ensuring that capital is flowing towards truly sustainable outcomes is a critical aim of the new European Union regulations. However, we fear that recent analysis of many of the products that have moved from Article 6 (which includes strategies that may have some form of ESG integration in the sense that they consider ESG risks from a financial perspective, but which do not have any binding obligation to consider the external harm caused by companies to the environment and/or society) to Article 8 (and even Article 9) funds (i.e. funds which promote ESG characteristics or target sustainable investments) paints a different picture. It perhaps suggests that ‘business as usual’ investment is being relabeled under a sustainable banner in light of increased investor demand for such products. There is a critical eye to this perception in the market, with negative headlines being fast to call out any manager that has opted to make Article 8 or Article 9 disclosures in relation to strategies for which they had never made specific reference to ESG considerations in the past and with limited changes to the actual investments made.
A Revolution in Economic Thinking
We know that, in addition to the need for capital to go towards truly sustainable investment opportunities, markets must start factoring in the value placed on negative external consequences created by companies. To us, one of the biggest and most consistent market failures is that investors have failed to integrate these considerations for decades. In their defense, this has to a large extent been because governments have been slow to legislate or have failed to penalize those responsible for the negative effects of those external consequences. In order to achieve a sustainable ‘revolution’, we believe we also need to undergo a revolution in economic thinking. The conventional economics that have underpinned investments and fundamental analysis for decades fall short in the face of the biophysical boundaries to our planet, such as climate change, water scarcity, topsoil erosion and loss of biodiversity, to name a few.
At Newton, our long-term strategy with respect to responsible and sustainable investing is focused on this transition. We call it ‘responsible investment 2.0’ but, in reality, it may be ‘responsible investment 3.0’. Over the last decade, our responsible investment team has been supporting our investment teams with dedicated and proprietary ESG analysis on companies as a complement to the analysis of external service providers. The benefit is that this analysis has been carried out by responsible investment specialists, who have had a direct understanding of the issues and have been able to guide the investment teams. However, while such an approach has helped our equity-focused research analysts to capture relevant, material ESG issues, many longer-term sustainability considerations may not be financially material over a typical investment horizon or singularly relevant to an investment case.
As we support the transition towards truly sustainable investment opportunities, we believe that ESG-related risks, issues and opportunities must be integral to the investment decision, in addition to being part of the ‘mosaic’ of inputs captured during the research process. In this context, our recent focus within the responsible investment team has been to hand over the direct responsibility for conducting ESG analysis to our equity-focused research analysts, and to help equip them with the skills to integrate that analysis to the highest standard.
This evolved process is starting to support the vision of the ‘new’ economic model that we believe we need to work to. Our vision is one of true integration: active stewardship roles for the investment teams, which ensure their accountability and ownership for the risks they buy on behalf of our clients. It’s a transformation that we believe needs to happen more widely in our industry.
The evolution of roles is supported by a well-resourced central responsible investment team, whose task is to undertake specialist research, in collaboration with the investment team, and provide support, where needed, on company engagements, as well as to develop tools and insights through ESG data. By creating a partnership between our investment and sustainability skillsets, we believe we can get the best of both worlds and build genuine thought leadership that should help us outperform for our clients.
A great example of where this is needed more than ever is in the efforts around achieving net-zero carbon emissions. This is an issue that can never be solved solely by a single responsible investment team or by any industry in isolation. For the necessary transition that needs to happen around energy, or any other system, we believe we must invest with a deep understanding of the issues across our investment teams.
This includes not only the way we build solutions, but also how we evaluate our integration processes. Ultimately, it’s about allocating to companies that we believe are best positioned to be truly sustainable, and which do their utmost to be leaders in their respective fields.
[1] SFDR is a European regulation that aims to make different investment products (such as funds) easier to compare on a like-for-like basis, and more easily understood by investors. Under SFDR, funds that are made available to European Union investors need to make specific disclosures depending on the way they are managed, and it has become common practice to refer to products as Article 6, Article 8 and Article 9 products depending on the disclosures that are made. In broad terms, Article 8 funds promote environmental or social characteristics, while Article 9 funds have sustainable investment as their objective. Any funds that are not classified as Article 8 or Article 9 funds will often be described as Article 6 funds, meaning that they are not obliged to take sustainability factors into account when they make investments (although they may take account of sustainability risks affecting the value of investments depending on the nature of the product).
Authors
Therese Niklasson
Global head of Sustainable Investment
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